The business cycle

France: Rebalancing the economy is tough

By February 23, 2018 December 11th, 2018 No Comments

…but at least France is trying

Since our last update in December 2017, we have turned more constructive on the cyclical outlook, as we see real GDP growth staying above 2% in 2018/19E, thanks largely to the favourable global backdrop. Our inflation projections instead remain unchanged, at 1.4-1.5% in 2018/19E, as we see some growing company appetite for higher prices, but equally a fast response from consumers to scale down spending if inflation runs too high.

President Macron has delivered many changes in less than a year in office, touching on all the key three areas that, in our view, were a priority for the electorate: jobs, taxes and education. While the activism and breadth of changes are laudable, we see three obstacles. Greater labour flexibility, coupled with the fact that France has among the highest compensation levels in the EU, in the bottom 40% of the income distribution, in our view, should lead to the repricing of wages lower, in time. This is doomed to hurt his approval rating and caps consumption potential. Secondly, we suspect he has not put enough resources into supporting SMEs: the business sector in France is dynamic, but small companies in this world are ferociously disadvantaged. To prosper, they need more help. Last, but not least, relative to people’s perceptions of what the education sector needs, the recently-announced reform may materialise too slowly.

Forward-looking indicators suggest that both exports and investment should continue to fare well. Industrial sector expectations for exports stayed high in 1Q18, close to the previous peak of 2011, and capacity constraints are beginning to bite, suggesting that investment should continue to stay brisk in the coming quarters.

But be mindful of the fragilities. On the investment front, inventories stand at a 17-year high of 1.7% of GDP and, thus, while accumulating inventories have a positive effect on GDP growth, sooner or later they will need to be run down, which will have the opposite effect. On the consumption front, we noted that French households already benefit from super-low interest rates and high wages (compared with most of the other EU countries). As QE is slowly coming to an end, there is no further space for reducing borrowing costs.

Bond yields: have we seen the peak of the long end already? Today, we introduce our bond yield model for the 10yr part of the curve. The message of our model is that the market is already pricing in fully the likely inflation and monetary policy outlook. This stands in contrast with our models’ message for BTPs and Bunds.

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